FOOL ON THE HILL
Cisco's Hubris

While confidence and comfort with technology might be two hallmarks of good executives and money managers, in two well-documented cases -- networking equipment maker Cisco and hedge fund flop Long-Term Capital Management -- the principals involved may have taken both too far. In this article, Whitney Tilson explores the dangers hubris and overreliance on computer forecasting can pose.

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By Whitney Tilson
August 14, 2001

While I've written on the perils of investor overconfidence and how humility is one of the key traits of successful money managers, it's only recently that I've come to realize how the use of computers -- computer models, to be precise -- combined with hubris can lead to disaster.

In an increasingly complex world, it has become natural to turn to computers. To be sure, the overall results have been remarkable. Productivity in the United States has boomed. In the realm of investing, computers and the Internet have leveled the playing field and allowed investors of all stripes to access immense quantities of valuable data. In the corporate world, companies have integrated technology to communicate better with customers and suppliers, squeeze inventories, cut costs, and so forth.

But while computers are useful for modeling the past and managing the present, they can be dangerous when used to predict the future, as the case studies of Cisco (Nasdaq: CSCO) and hedge fund Long-Term Capital Management illustrate.

Cisco
The general story behind the contraction of Cisco's business (and stock) is well-known. As recently as a year ago, the company was growing, as it had for nearly a decade, at rates of approximately 50%, and its management confidently projected 30%-50% growth rates for the foreseeable future. (The company has still not backed off of this forecast, though CEO John Chambers recently conceded that it was a "stretch" goal.) To meet expected demand, Cisco loaded up on inventory. When the economic slowdown hit the technology sector, however, Cisco's business dried up, saddling the company with declining sales and huge inventory write-offs.

What is less well-known is how Cisco's vaunted "virtual close" software contributed to management mistakes that led to the company's difficulties. According to a fascinating article in CIO Magazine, "What Went Wrong at Cisco":

"Cisco has aggressively marketed [its software] as a huge competitive advantage. In numerous news accounts, CFO [Larry] Carter was quoted as saying that these systems made the company both huge and nimble, Goliath's brawn with David's agile sling.

"CIOs were envious, competitors fearful. No one came away from a virtual close demo without high praise, like Fortune: 'Cisco uses the Web more effectively than any other big company in the world. Period.' Or Business Week: 'It should mean zilch-o earnings surprises.'"

But forecasting demand is notoriously difficult. It not only requires data and computer models, but also scuttlebutt and, most importantly, human judgment. This, apparently, is what was sorely lacking at Cisco.

Looking only at past and current demand, it's not surprising that Cisco's computers projected booming demand as recently as late last year. That's no excuse, however, for management's apparent blindness to the slowdown so apparent to everyone else.

As recently as last December, with the Nasdaq meltdown in full swing, Chambers crowed to analysts, "I have never been more optimistic about the future of our industry as a whole or of Cisco." Such comments, while vague, might not have been wholly appropriate at the time given the economic context, and it seems the mind-boggling hubris of Cisco's managers -- combined with an excessive reliance on computer models -- led the company to make disastrously over-optimistic decisions.

Long-Term Capital Management
The story of Long-Term Capital Management's blow-up, told best in Roger Lowenstein's outstanding book, When Genius Failed, is nearly as well-known as Cisco's. LTCM became one of the largest and most acclaimed hedge funds in the world, based on its spectacular performance -- it more than quadrupled -- from its inception in 1994 through early 1998. Then, during the crisis triggered by Russia's bond default in August 1998, LTCM unraveled and its investors lost nearly everything.

While Cisco's demise has been nowhere near as severe as LTCM's -- Cisco has no debt and plenty of cash, so it's not going out of business -- the parallels between what happened to Cisco and LTCM are striking. Like Cisco, hubris blinded LTCM to risk. Such a long period of sustained success convinced LTCM's leaders they could do no wrong, and they consequently started making larger, more highly leveraged bets.

Like Cisco, LTCM relied heavily on computer models, developed by Nobel prizewinners Robert Merton and Myron Scholes, who were among the founders of LTCM. Like Cisco, LTCM did not recognize that increasing size reduced flexibility and made 40% or more annual growth nearly impossible. Like Cisco, LTCM refused to acknowledge a more competitive environment. And finally, like Cisco, after the blow-up LTCM's managers did not accept responsibility for their ghastly mistakes, instead insisting they were helpless victims of a rare and unforeseeable "100-year storm."

"There is nothing like success to blind one to the possibility of failure," Lowenstein wrote. "At the very time when the outlets for their narrow skills were closing, the partners tossed off their innate caution, which had served them so well, like an old suit."

Identical words could be written about Cisco.

Lessons for investors
These stories illustrate four major lessons for investors. First, be careful to avoid the trap Warren Buffett wrote about in his brilliant November 1999 Fortune article: "As is so typical, investors projected out into the future what they were seeing [in the past and present]. That's their unshakable habit: looking into the rear-view mirror instead of through the windshield." The past can be an accurate guide to the future -- but don't count on it.

Second, while computers are wonderful tools for gathering and analyzing data, they cannot consistently and accurately predict the future of extremely complex systems such as stock markets or individual companies and stocks. This requires -- and, dare I say, always will require -- human judgment.

For this reason, I don't use discounted cash flow spreadsheets to value stocks. While future cash flows are, of course, critical to determining value, such spreadsheets are dangerous because their precision can give one a false sense of security. An investor's time is better spent thinking about such factors as a company's economics, or whether its competitive advantages are sustainable. Then, when it comes to valuation, only buy when a stock is so cheap that a spreadsheet is unnecessary. As Buffett said at Berkshire Hathaway's (NYSE: BRK.A) 1996 annual meeting in response to Charlie Munger's comment that he has never seen Buffett use a spreadsheet: "It's true. If [a company's value] doesn't just scream out at you, it's too close."

Third, when it comes to the stock market, so-called "100-year storms" are far more frequent than such a name suggests. As Lowenstein put it, "stocks (or bonds) are often inexplicably volatile... [They] run to extremes more often than coin flips -- and more often than the 'hundred-year storm' that Long-Term's partners would later cite as the culprit behind their disaster... The coin doesn't remember that it landed on tails three times in a row; the odds on the fourth flip are still 50/50. But markets have memories. Sometimes a trend will continue just because traders expect (or fear) that it will... No matter what the models say, traders are not machines guided by silicon chips; they are impressionable and imitative; they run in flocks and retreat in hordes."

This is why I don't short stocks or use leverage. I expect to encounter a number of so-called 100-year storms in my investment career, and I want to survive them. In 1996 -- ironically, at the same time LTCM was soaring -- Munger echoed these sentiments: "Warren and I are chicken about buying stocks on margin. There's always a slight chance of catastrophe when you own securities pledged to others." Buffett put it more succinctly a few years earlier: "You will someday hit a pothole."

The final lesson is the importance of humility. Had Cisco's and LTCM's managers been willing to acknowledge that the future is always unpredictable and that their forecasts might be wrong, they surely wouldn't have made such aggressive bets, and consequently they -- and their investors -- might have avoided much unnecessary pain.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Berkshire Hathaway at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.